Blockchains and their products have beyond doubt been the center of many controversies throughout the years. There is virtually no person with access to the internet who has never heard of Bitcoin and Ethereum, but what mainstream media fail to portray, is that these coins are nothing more than the tip of the iceberg — an iceberg filled with groundbreaking innovations with the power to revolutionize entire industries. One such field is DeFi.

DeFi stands for Decentralized Finance — A fascinating area of blockchain applications that aims to decentralize financial instruments and tools ranging from currency exchange to lending. In fact, since the beginning of 2020, the total value locked in DeFi projects has seen a 50 fold increase, currently being worth $50 Billion.

This article will serve as the complete guide into understanding Flash Loans — one of the most profitable products of DeFi — while outlining ways to make money using them and exploring real-life examples.

Flash Loans

In simple terms, Flash Loans are Unsecured Loans — loans that require no collateral and no authorization based on factors such as credit score, use-cases, etc. In other words, anyone can get a loan of $10,000,000 without being asked any questions.

Such a statement undeniably raises a number of red flags. “How does the lender know I will not just take the money and never repay them?” you may ask.

The answer is simple: Borrowers must repay the funds in the same transaction where they were borrowed.

This might sound impossible, as in traditional finance a transaction would be considered a single operation where for instance, person A transfers an amount to person B. In DeFi though, and specifically Smart Contract development, the sense of the word changes completely.

A transaction is considered a series of operations that take place together. In the case of a Flash Loans a basic transaction would be the following:

1. Borrow a 10,000 ETH Flash Loan

2. Exchange the ETH for some DAI on exchange A

3. Exchange the DAI for some ETH on exchange B

4. Reimburse the Loan+ fee

Of course, this entire pipeline of operations can be programmed by the user to perform any tasks of their choice (more on that in a bit). The main takeaway is that whatever strategy the borrower wants to employ, it must take place in the same transaction where they funds are borrowed and repaid.

Users can thus borrow millions of dollars worth of currencies without being required to have any liquidity prior to the taking the lone (it must be noted that similarly to any transaction on the Blockchain, the user is required to pay the Gas Fees of the transaction).

Flash Loan Use Cases

But what are the use cases of a Flash Loan? “If I have to repay the funds as soon as I borrow them how can I make money?” you may ask. The answer is that the use cases are unlimited. Nevertheless, in the context of this article, the three most common ones will be explored.

Arbitrage

Arbitrage consists of one of the most wide-spread and common techniques were Flash Loans are used to yield profitable results. Similarly to traditional arbitrage the aim is to detect and “exploit” inconsistencies in the prices of tokens between exchanges. For a better understanding of how Flash Loans can be used in the context of arbitrage, the following hypothetical scenario is to be explored:

* The exchange rate for ETH/DAI on Exchange A is 1/2000

* The exchange rate for ETH/DAI on Exchange B is 1/2010

Step 1: Borrow 1,000 ETH from Exchange A (a value of 2,000,000 DAI)
Step 2: Exchange the 1,000 ETH for 2,010,000 DAI on Exchange B
Step 3: Exchange the 2,010,000 DAI for 1,005 ETH on Exchange A
Step 4: Reimburse the initial loan with the 1,000 ETH, keeping 5 ETH as profit

Although the above scenario would yield a profit of $10,000 without having to provide any liquidity of your own, it is important to note that exchange fees were not accounted for.

The other important aspect of arbitrage-based strategies is that a system must be in place in order to detect these opportunities as they are rare and with minor time windows.

Collateral Swapping is another possible strategy borrowers can use to profit from Flash Loans. Essentially, existing collateral positions can be replaced with the Flash Loan borrowed asset, despite the fact that the borrower is unable to return the funds.

In the hypothetical situation where a borrower is providing collateral to Decentralized Exchange A using token X, but they notice a decline in token X’s price, a Flash Loan on another token Y could be used to swap the collateral and avoid liquidation.

Low Transaction Fees

As it was outlined above, an intrinsic characteristic of a Flash Loan is that all operations are performed within the same transaction. On blockchains such as Ethereum where transaction fees are extremely high and the gas for a transaction can reach hundreds of dollars, being able to condense different actions within one optimized transaction can save hundreds if not thousands of dollars worth of fees.

The bZx Incident

As with most things Flash Loans can be used for malicious purposes. The only difference here is, that with DeFi projects and tokens not being considered registered securities, ingenious and highly knowledgeable traders are able to exploit different projects and be rewarded generously in the process. A prime example of such an “ingenious attack” was the “bZx incident” that took place earlier this February — An attack which yielded millions of dollars worth of profits.

During the attack, 7,500 ETH were borrowed on bZx, swapping them for SUSD, consequently pumping up the price. The increased volume made the price of SUSD almost triple, far surpassing its market value that was set at $1.

With bZx being heavily dependent on Kyber’s (another decentralized exchange) pricing data, the attacker decided to put the SUSD as collateral for a loan they took on bZx — a loan which due to the artificially created price increase allowed the attacker to receive 2,000 more ETH than what they would have normally received with the same amount of SUSD collateral.

After reimbursing the value of the initial flash loan, the attacker refused to pay back the second loan, forcing bZx to liquidate his collateral, leaving them with a profit of 2,378 ETH ($4,750,601.94 at the time of writing this article).

Not bad isn’t it?

Conclusion

To conclude, Flash Loans are amazing financial instruments that simply showcase the power of DeFi and the innovation they bring to the financial world. At the same time, it is evident that a number of opportunities are also available for retail traders who now have the power to trade in millions of dollars, further democratizing the financial world.

Although, as proven by the bZx attack, there are flaws in the systems, these same flaws can enable users to legally “exploit” them and make unimaginable profits in the process.

Whatever the case, these opportunities are rare and often come with extreme risk (that in most cases are not worth it). With Flash Loans being nothing more than a tool, it is up to the individual to evaluate and decide whether a possible opportunity for making a profit is worth it compared to the involved risk.